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NState transfer pricing—Preparing for increased scrutiny of intercompany transactions
Mike Bryan
Deloitte Tax LLP
Paul Buchman
Tyco International
Peter L. Faber
McDermott Will & Emery LLP
1 Copyright © 2016 The National Multistate Tax Symposium: February 3-5, 2016
• Transfer pricing (TP) refers to the pricing used in
intercompany transactions within a group of controlled
taxpayers
• TP affects the allocation of the total profit among related
taxpayers
• Key driver for global tax rate
• Critical to global cash and tax management strategy
• Multitude of multistate and local country tax and indirect tax
considerations
• Tax authorities can make transfer pricing adjustments even
if the taxpayer did not intend to inappropriately shift income
through transfer pricing
Overview: What is transfer pricing?
2 Copyright © 2016 The National Multistate Tax Symposium: February 3-5, 2016
In any case of two or more organizations, trades, or businesses
(whether or not incorporated, whether or not organized in the United
States, and whether or not affiliated) owned or controlled directly or
indirectly by the same interests, the Secretary may distribute,
apportion, or allocate gross income, deductions, credits, or
allowances between or among such organizations, trades, or
businesses, if he determines that such distribution, apportionment, or
allocation is necessary in order to prevent evasion of taxes or clearly to
reflect the income of any of such organizations, trades, or businesses. In
the case of any transfer (or license) of intangible property (within the
meaning of section 936 (h)(3)(B)), the income with respect to such
transfer or license shall be commensurate with the income attributable to
the intangible.
IRC § 482
3 Copyright © 2016 The National Multistate Tax Symposium: February 3-5, 2016
• Key components of the final IRC §482 regulations are as follows:
− Arm’s-length principle—results of the transaction are consistent with
the results that would have been realized if uncontrolled taxpayers had
engaged in the same transaction under the same circumstances.
− Best method rule—a method that provides the most reliable measure
of an arm’s-length result.
− Comparability—specific factors should be considered when
determining comparability.
• IRC § 482 is not self-executing. It provides the IRS discretion to make
adjustments.
IRC § 482 regulations
4 Copyright © 2016 The National Multistate Tax Symposium: February 3-5, 2016
Tangible property transactions
• Sale of tangible products for distribution to customers
Intangible property transactions
• Licensing of intellectual property (includes patents, know-how, trade secrets,
etc.)
Services
• Management services
• Technical services (e.g., IT support, sales support, etc.)
• Sales and marketing services
Financial Arrangements
• Loans/guarantee fees/cash pooling
Cost sharing arrangements
• More than one affiliate in the group contributes resources to a common goal,
such as to develop intangibles.
Overview: Examples of intercompany transactions
5 Copyright © 2016 The National Multistate Tax Symposium: February 3-5, 2016
• Reviewing intercompany agreements and course of conduct to
accurately delineate the intercompany transactions
• Determining the relative functions performed, risks assumed and assets
employed by the respective related taxpayers
• Selecting the best method to test the results of the intercompany
transactions
• Reviewing comparables to calculate an arm’s length range of results
• Comparing the taxpayers’ actual results to calculated arm’s length range
Transfer pricing analysis (key elements)
6 Copyright © 2016 The National Multistate Tax Symposium: February 3-5, 2016
• A report that analyzes related party transactions during the just completed tax
year.
• Provides protection against transfer pricing adjustment penalties.
− Must satisfy reasonable basis standard.
• Note that this is a different level of authority than is required by some
states.
− Must contain the 10 principal documents. (see Treas. Reg. 1.6662-
6(d)(2)(iii)(B))
− Must be completed in draft form contemporaneously with tax return (does not
get filed with tax return), AND be provided to IRS within 30 days of request.
• Components of a documentation report
− Statement of facts—describes the taxpayers’ activities and relevant related
party transactions.
− Economic analysis.
− Results of the economic analysis are compared to actual intercompany prices
to show that they were at arm’s-length.
US Transfer pricing documentationTreas. Reg.§ 1.6662-6
7 Copyright © 2016 The National Multistate Tax Symposium: February 3-5, 2016
• Character of related parties (entrepreneur vs. routine functions, conduct
vs. contracts)
• Royalties (lack of benefit, value compared to local contributions)
• Service charges (benefit, cost base, pass-through costs, stock-based
compensation, and markups)
• Tangible goods (embedded royalties, bundled transactions)
• Recurring local losses treated as a service to the global group
Common TP audit issuesFederal
7
Transfer pricing: Current
state tax environment
9 Copyright © 2016 The National Multistate Tax Symposium: February 3-5, 2016
States may seek to impose IRS § 482-type powers in the following ways:
• Adopting the IRC by reference, including § 482
• Adopting federal taxable income as the starting point in determining
state taxable income
• Adopting statutes analogous to IRC § 482
• Commissioner’s discretion
• UDITPA provides rules regarding the allocation and apportionment of
income among states
State adoption/conformity to IRC § 482
10 Copyright © 2016 The National Multistate Tax Symposium: February 3-5, 2016
State statutes typically use one of the following ways to address
intercompany transactions:
• Disallowance of deductions for specific payments made to related
parties (the add-back rules)
• Changing the value of transactions between related parties (IRC § 482
principles) and treating adjustments as transfers
• Forced combination or consolidated filing including tax haven countries
• Asserting jurisdiction over a non-filing entity based on the related party
attributes in the state (i.e., “Geoffrey” nexus)
• Applying economic substance, business purpose, or sham transaction
doctrines (striking down the arrangement)
State authority—intercompany transactions
11 Copyright © 2016 The National Multistate Tax Symposium: February 3-5, 2016
State audits of intercompany transactions
• Audits are generally tougher and take longer
− Fact intensive IDRs
• More aggressive audit assessments and increased litigation
• Increased focus on transfer pricing and related documentation
− Jurisdictions have engaged third-party specialists
− Court filings in District of Columbia
• Increased focus on economic substance/business purpose
• Royalty and interest transactions closely scrutinized
Recent state tax authority audits
12 Copyright © 2016 The National Multistate Tax Symposium: February 3-5, 2016
Supply-chain based structures
• Should have substance and be supported by business purpose
• Generally not subject to add back
− Flows of tangible property
• States forcing select combined filing
• Attacks are increasingly based on pricing
Focus on embedded royalties
• Difficult to identify and isolate
• Structural challenges
Recent state tax authority audits (cont.)
13 Copyright © 2016 The National Multistate Tax Symposium: February 3-5, 2016
Have written agreements.
• They should be as detailed as an agreement with an unrelated party
would be.
• The agreement should provide for actual payments for goods and
services, not just for bookkeeping entries.
• The term should be consistent with commercial custom.
• Accounting records should support the financial structure of the
transaction.
Practical considerationsImplementing the structure
14 Copyright © 2016 The National Multistate Tax Symposium: February 3-5, 2016
• Agreements should be detailed and spell out all the services to be
provided.
• Fee is typically based on cost plus a profit mark-up (e.g., between 5
percent and 10 percent).
• Allocating the fee among service recipients.
• Impractical to base it on value of services provided to each company.
• Allocations based on gross revenues or gross profits are generally OK.
Allocations based on net income are not.
Practical considerationsManagement services agreements
15 Copyright © 2016 The National Multistate Tax Symposium: February 3-5, 2016
• Execute loan documents
• Must contain third party formalities—default and enforcement provisions
• Fixed interest rate/principal/maturity date
• Performance
• Timely payments that are consistent with the note
• Financial records support the repayment of the loan
• Ledger/bank statements
• Cash transfers
• Debt/equity analysis
• Federal and state case law
• Can the debtor repay the loan
− Cash flow
− Earnings
− How would a bank or credit agency rate the debt
Practical considerationsAdministering financial arrangements—loans/cash management
16 Copyright © 2016 The National Multistate Tax Symposium: February 3-5, 2016
• Provide a memorandum to the business people at the outset.
• Company personnel may follow the rules at the start but may be less
conscientious as time passes. Tax personnel should monitor compliance
on a regular, periodic basis.
• Payments should be made when due. Goods and services should be
provided timely and efficiently.
• Evaluate the fairness of the pricing periodically.
Practical considerationsAdministering transfer pricing arrangements
17 Copyright © 2016 The National Multistate Tax Symposium: February 3-5, 2016
• Emphasize and document business reasons for the arrangement.
• If the corporate parties to the arrangement are different profit centers for
purposes of internal accounting and employee compensation, this
should be emphasized.
• If you have good documentation, produce it early in the process.
• Use your experts early in the process. Don’t rely on general statements
about compliance with arms-length standards.
• If an auditor disallows a transfer pricing transaction, request a written
explanation of the denial.
Practical considerationsAudits and controversies
18 Copyright © 2016 The National Multistate Tax Symposium: February 3-5, 2016
• It is generally acceptable to use a company that has a prior relationship
with the taxpayer. Its professionals understand the company’s business.
• Use an individual who would be a good expert witness.
• Retain a consultant when the arrangement is being established for the
purpose of advising on what the pricing should be. Do not wait until the
tax audit.
• Negotiate the engagement letter.
Practical considerationsRetaining a consultant
19 Copyright © 2016 The National Multistate Tax Symposium: February 3-5, 2016
Should the consultant be retained by an attorney to bring its work within
the attorney-client privilege (i.e., a Kovel arrangement)?
• Not if retention is to aid company in pricing sales. The privilege is
available only if the retention is to help the attorneys give legal advice.
• Perhaps, if the retention is in connection with a tax audit.
• Review report carefully. Make corrections.
Things to watch out for:
• Facts should be accurate.
• Purpose should be stated (e.g., to assist the company in pricing
transactions).
• Comparables should really be comparable.
• Excessive boilerplate language is generally bad (as are too many
references to the 482 regulations).
Practical considerationsRetaining a consultant
20 Copyright © 2016 The National Multistate Tax Symposium: February 3-5, 2016
• Base Erosion and Profit Shifting (BEPS) refers to tax planning
strategies that supposedly exploit gaps and mismatches in tax rules to
artificially shift profits to low or no-tax locations where there is little or no
economic activity, resulting in little or no overall corporate tax being
paid.
• Organisation for Economic Co-operation and Development (OECD)
estimates annual losses of anywhere from 4-10 percent of global
corporate income tax revenues, i.e., $100 billion to $240 billion annually.
• Per the OECD: “Fifteen actions equip governments with the domestic
and international instruments needed to tackle BEPS. The final BEPS
package gives countries the tools they need to ensure that profits are
taxed where economic activities generating the profits are performed
and where value is created, while at the same time give business
greater certainty by reducing disputes over the application of
international tax rules, and standardising compliance requirements.”
OECD BEPS Initiative
21 Copyright © 2016 The National Multistate Tax Symposium: February 3-5, 2016
Action 1–Address the Tax Challenges of the Digital Economy
Action 2–Neutralise the Effects of Hybrid Mismatch Arrangements
Action 3–Strengthen CFC Rules
Action 4–Limit Base Erosion via Interest Deductions and Other Financial Payments
Action 5–Counter Harmful Tax Practices More Effectively, Taking into Account Transparency and
Substance
Action 6–Prevent Treaty Abuse
Action 7–Prevent the Artificial Avoidance of PE Status
Actions 8-10–Assure that Transfer Pricing Outcomes are in Line with Value Creation
Action 11–Measuring and Monitoring BEPS
Action 12–Require Taxpayers to Disclose their Aggressive Tax Planning Arrangements
Action 13–Re-examine Transfer Pricing Documentation
Action 14–Make Dispute Resolution Mechanisms More Effective
Action 15–Develop a Multilateral Instrument
BEPS Action items—TP impact(Actions in bold are relevant to TP)
22 Copyright © 2016 The National Multistate Tax Symposium: February 3-5, 2016
Country-by-Country reporting
23 Copyright © 2016 The National Multistate Tax Symposium: February 3-5, 2016
Country-by-Country reporting
24 Copyright © 2016 The National Multistate Tax Symposium: February 3-5, 2016
• Participating states: AL, IA, KY, NJ, NC, PA
− Program not ratified at MTC annual meeting
− MTC continues to encourage other states to participate
• Potential exists for state revenue agencies to be supported by external
economic consulting firms in the following areas:
− Training
− Audit selection
− Economic analysis
− Litigation support
• Some states may find alternative solutions
Multistate Tax CommissionArm’s-Length Adjustment Service (ALAS)
25 Copyright © 2016 The National Multistate Tax Symposium: February 3-5, 2016
Contact information
Michael Bryan
Paul Buchman
Peter Faber
26 Copyright © 2016 The National Multistate Tax Symposium: February 3-5, 2016
This presentation contains general information only and the respective
speakers and their firms are not, by means of this presentation, rendering
accounting, business, financial, investment, legal, tax, or other
professional advice or services. This presentation is not a substitute for
such professional advice or services, nor should it be used as a basis for
any decision or action that may affect your business. Before making any
decision or taking any action that may affect your business, you should
consult a qualified professional advisor. The respective speakers and their
firms shall not be responsible for any loss sustained by any person who
relies on this presentation.